The Real Problems With Debt Inflation

For decades, western economies have weakened their prospects for real growth through flawed "economic" doctrines focusing on increasing consumption rather than production, making but one thing possible: an ever growing mountain of money. In the eurozone today, government debt is well above 90%. On the other side of the Atlantic, the country that has dominated not only the business world for a century or more, the 100% mark was quickly surpassed in the aftermath of the 2008 banking crisis.

As money is created as debt and as banks and their central banks in tandem with governments have successfully fostered an ever growing expansion of the money supply (and hence debt), I thought it was appropriate to take a closer look at the economic meaning and consequences of debt. Simultaneously, I hope to shed perhaps a little light on why economic growth in the U.S. and other debt-infused countries (i.e. most of the developed world) is likely to be dismal at best for a long time.

Debt can come in many forms. The one we are concerned with here is of the monetary kind where one party borrows money from another. Through taking on the debt, the borrower obtains increased purchasing power now. With the newly attained purchasing power, the borrower is able to spend or invest more today than otherwise. The borrower will however face diminished purchasing power in the future when the loan is repaid. The lender on the other hand relinquishes purchasing power today and is hence able to spend less now than otherwise. If the borrower honours the terms of the agreement, the lender will attain increased purchasing power in the future when the borrower repays the loan.

As long as someone has actually previously saved the money lent out, no specific problems arise. As savings is the excess of production over consumption, the lender merely transfers the rights to purchasing power, represented by the amount saved, to the borrower. Nobody loses, at least ex ante and as long as it is based on voluntary terms. Arguably more important, as we shall see below, others not involved in the transaction do not suffer from decreased purchasing power. This ceases to be true however when banks lend money into existence as it leads to an increase in the money supply. As new money is created as debt, the money supply grows when banks issue loans that are not issued on the back of prior savings. The debt we will focus on here is therefore the kind that is lent into existence by banks as made possible only through the very existence of an elastic currency; meaning the quantity of money is able to change rapidly with changing demand.

The elastic money supply employed today is made possible through government fiat (i.e. law, hence fiat money). Nobody else is allowed to create these fiat monies as it would be considered counterfeiting. In the current monetary system, banks and central banks hence have a monopoly on creating money. When a bank lends money into existence, it creates an asset (the loan) and a liability (the deposit) on its balance sheet. As bank deposits are money, the newly created deposit is hence newly created money and thus serves to increase the money supply in an economy. The borrower on the other hand records an asset (the cash deposited in the borrower's account) and a liability (the loan - the money borrowed). Economically speaking, what happens in this transaction is that the purchasing power available to the borrower increases right now while the bank's purchasing power remains unchanged. Actually, the banking system's purchasing power will increase once the borrower spends the money and the new owners of the money deposits them back in the banking system. This increased purchasing power stems from the fact that the deposit increases the amount of bank reserves. This increase allows banks to extend further loans or to buy securities.

The initial increase in spending power of the borrower and the ensuing increase in the pending power for banks is in stark contrast to what happens when a loan is granted from prior savings where purchasing power is merely transferred from one party to another as explained above. When new money is lent into existence, the additional purchasing power needs to come at the expense of someone else as the granting of the loan did not increase the amount of resources available in the economy; more money is now chasing the same amounts of goods and the purchasing power of money drops accordingly. The elasticity of money therefore makes it possible to impose a loss of purchasing power onto others, i.e. those that did not receive the new money ends up paying for those granted the additional purchasing power. And as banks did not lose purchasing power when granting the loan and actually gains purchasing power once the deposit money is re-deposited, it is especially the non-bank, non-borrowing public that ends up paying for it. This helps shed light on why savings relative to GDP has radically declined in the U.S. since the end of Bretton Woods in 1971.

The elasticity of money also explain the growth and rising stature of the banking sector especially since the mid 1990s. Through the money creation process, a portion of non-banking wealth is gradually transferred to banks making the sector relatively richer and the real economy relatively poorer in the process.

Something else happens as well when loans issued are not based on prior savings. Whether the loan is granted based on prior saving or lent into existence, there is never any guarantee that the borrower will be able to pay back the loan in full. When a loan is based on prior savings however we know resources have actually been made available through the act of saving. All that can be squandered is therefore the amount of prior savings. This is not the case when money is lent into existence; resources have neither been freed nor are there any guarantees the borrower will be able to repay the loan. The economy's overall risk exposure hence increases as a result. More specifically, the risk of society running out of resources at a later stage due to too many commitments increases when lending is not based on prior savings. The two cases can hence be contrasted as follows:

• Lending based on prior savings: future production is necessary to pay off the debt.

• Lending money into existence: future production is necessary to pay off the debt and an increase in future savings is necessary to replenish the initial savings deficit.

The future is always uncertain. When banks expand their portfolios of loans unbacked by prior savings this will serve to increase the risk of adverse economic outcomes furthein the future as savings are depleted and financial leverage increases, e.g. a decrease in the ratio of net saving to GDP (see chart above). This increased risk is independent on whether the additional purchasing power is spent on investments or consumption, though the two have different impacts on how the economy reacts.

Fundamentally, what is happening is this: money lent into existence allows a society to simultaneously increase both current consumption and investments independent on whether resources have actually been freed or not for such purposes. This increase in both consumption and investments will serve to

1. reduce resources available that could have been used for other purposes
2. reduce the existing pool of monetary savings through a reduction in its purchasing power
3. create economic imbalances as more is consumed and invested today than current savings suggests

In short, consumption and investment increases above and beyond what is sustainable. This will lead to less production and consumption in the future as saving, the only means to grow investments and increase productivity on a sustainable basis, is gradually being depleted. More debt and less saving today mean lower consumption and economic growth or contraction in the future.

One final point: debt unbacked by prior savings are granted in the form of increased current purchasing power for the borrower at no loss to the banks as the newly created deposits are effectively created out of thin air. The borrower however acquires real resources with the new purchasing power and also, and this is important, needs to pay back the loan with real resources. I say real resources as the borrower needs to create enough income or profits through selling goods or services (e.g. labour, running a profitable business) to be able to service the debt as the borrower does not own a printing press. As the initial debt depleted these very real resources, ultimately some of the borrowers will fail to acquire a sufficient amount of real resources to pay back the loan. This is when default occurs. The people in the economy have simply been living beyond means as evidenced by a depletion of savings relative to debt and income. The cushion or the rainy day fund is gone or greatly depleted. When this happens, it becomes apparent that the debt was granted at the time of a more prosperous economy when both savings and productivity were relatively higher. The debt remains fixed however and has not declined in tandem with the regressing economy. The increased scarcity of resources brought about by overconsumption and malinvestments makes it outright impossible for all the debt to be repaid.

The economy can only start recovering by admitting these losses, rebuild savings and accumulate capital. At this stage however, even if markets and the genius of the human mind and spirit were allowed to perform their magic, it would take years to accumulate a relevant amount of savings. If a path of further debt increases as a remedy for the debt problems are chosen instead, as is the norm these days, it will take a miracle, or the collapse of the existing monetary system, for the economy to ever take a turn for the better.

Related:

The Austrian Theory Of The Business Cycle - A Short Synthesis